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As exchange-traded funds gain more and more fans, brokerage firms are making it cheaper and easier for investors to use them as the main building blocks of a retirement portfolio. Just beware of the potential pitfalls.
Earlier this month discount brokerage Charles Schwab doubled the number of exchange-traded funds that could be traded for free on its online platform and rival Fidelity Investments immediately responded with a similar offer. As a result, investors can now buy and sell thousands of ETFs without paying regular commissions.
ETFs, which after years of explosive growth hold more than $3 trillion, are mutual funds that trade throughout the day like a stock. Most ETFs are index funds, meaning they track market benchmarks and boast relatively low investment fees. While there are plenty of similarities between ETFs and traditional index mutual funds, ETFs do offer some advantages, like de minimis investment minimums (in theory you can but just one share) and certain tax advantages when it comes to capital gains.
Low-cost ETFs can be like a “Swiss army knife” for investors, says Ben Johnson, director of passive funds research with Morningstar. “They can do a lot of different jobs for a lot of different people.”
But is building a portfolio with ETFs the right approach for you?
How the offers work
Schwab doubled the the number of ETFs available to trade for clients commission free to more than 500 staring March 1, and Fidelity essentially matched that, with 500 made available to trade for free beginning on Feb. 28. Vanguard already offers more than 1,000 ETFs free of commission.
Fidelity had formerly offered commission-free trades for a large suite of BlackRock’s iShares and its own ETFs. Fidelity said it was adding “smart beta” and “active” ETFs from a range of providers to the free-to-trade bucket. Schwab added funds from a number of providers to existing Invesco, State Street Global SPDR and WisdomTree offerings.
Among other brokerage platforms, Etrade offers 250 free-to-trade ETFS and TD Ameritrade offers more than 300. Clients of Bank of America’s brokerage platform Merrill Edge with at least $50,000 in their accounts get 30 free stock and ETF trades a month.
Typically it costs $4.95 to $6.95 a trade on major platforms. While that may not sound like much, fees can pile up if, say, you’re someone who plans to sock away a few hundred dollars every month, or who regularly rebalances to make sure market swings don’t throw your chosen blend of stock and bond investments out of whack.
By contrast thousands of traditional mutual funds have long been “no load,” or free to trade, although many place restrictions on how many trades shareholders can make in a given time period.
If investors are not careful, however, there is a danger of being penny wise and pound foolish with ETFs.
While Fidelity’s and Schwab’s ETF offers look attractive, the firms still plant to make money. Fund industry analysts say these deals are loss leaders to get customers to spend money on other products and services. That could mean enticing you to purchase more expensive actively managed funds; cash products, like sweep accounts that may offer sub-optimal interest rates; or add-on services for individualized advice.
Investors should also educate themselves on the pitfalls of ETF pricing, Andrew Craswell, senior vice president at Brown Brothers Harriman who works on ETF development for the private bank’s European operations. With a traditional mutual fund, investors are guaranteed a prices that matches “net asset value,” essentially the value of the fund’s underlying stock holdings, as of 4 p.m. on the day of the order.
While ETFs almost always trade at market prices that closely match their N.A.V.s, there is no such guarantee. In some instances, like the “mini flash crash” of 2015, ETFs have temporarily diverged sharply from their theoretical values. Craswell recommends investors use “limit orders,” which specify the price you are willing to accept for a given trade, to avoid the nasty surprises that can happen when orders at market price are mistimed.
Do you really need hundreds to choose from?
Oliver Pursche, chief market strategist at broker-dealer and money manager Bruderman Brothers says investors should be wary of ETFs that overthink the market.
While new offers mean investors can now trade many more niche and specialty funds for free, these tend to be far more expensive plain vanilla offerings. For instance, starting March 1, Schwab investors will enjoy free trades of the the Global X S&P 500 Covered Call ETF, an expense ratio of 0.65%, and the WisdomTree U.S. Multifactor Fund, with an expense ratio of 0.28%, among many others.
But investors pay handsomely for these niche strategies. The Schwab Broad Market ETF, also free to trade, costs just 0.03%.
When it comes to “smart beta,” “active” or “multifactor” funds, investors should ask themselves: “do you know what impact each of those factors have on the stock selection?”
“I believe in keeping them very simple and therefore low cost,” said Mr. Pursche.